Here's Why The Financial Transaction Tax Won't Work

As originally conceived by Nobel prize winning economist James Tobin in the aftermath of the collapse Bretton-Woods, the tax would have applied to currency trades. Tobin's point was to reduce the volatility he believed was caused by currency speculation by taxing each trade, which would reduce the overall volume of trades.

The "Tobin Tax" proposal never really went anywhere, in part because many policy makers understood that the upheavals in the global currency markets of the 1970s weren't the work of speculators but of profligate government spending. What's more, many realized that creating intentional illiquidity in markets was a recipe for mispricing that would likely result in more severe crises when the inevitable correction occured.

The Tobin Tax was briefly revived by Sweden, to disastrous effect. The tax was imposed on all stock and bond trading, rather than just currency trades. This had the effect of driving financial business out of Sweden and was repealed after just a few years. The lesson of Sweden is one reason financial regulators now advocating a new Tobin Tax insist it be adopted on an international scale.

The Tobin Tax's newest life comes in response, of course, to the bailout of the global financial system. The idea this time around isn't to drain liquidity from financial markets or even to discourage speculation. This time the tax is supposed to create a fund for future bailouts. Unfortunately, it will do nothing of the sort.

Let's imagine how this Financial Security tax would work. Outside of a financial crisis, the fund would produce a running surplus -- taking in more than it was spending to rescue failed financial firms. What would happen to that surplus? It would inevitably be spent rather than somehow saved for a future crisis.

If politicians allow the tax to just go into the general revenues of the government, the tax will simply become a new source for political spending. There would not even be an illusion of saving. Taxpayers wouldn't be relieved of any risk from future bailouts. Indeed, they would end up paying for future bailouts twice: at first in increased costs to their pension and mutual funds and later when the financial system would need to be rescued.

But even if politicians pretend that they aren't going to spend the funds immediately, they will end up doing so anyway. Let's say that instead of putting the revenues from tax into the general pool of tax collections, the government puts the money into a "Financial Security" fund. Where does the money go? Does it sit in a vault somewhere? Let's hope that vault is somewhere really safe because over the years it is going to accumulate a massive amount of money and quickly become the largest horde of treasure anywhere in the world.

More importantly, the fund would be a constant net drain on the money supply that would be highly deflationary. In order to balance out the deflationary effects, the Fed would have to have a looser monetary policy. This would have the ironic effect of having the Fed inject into banks the very funds just taken out of financial firms by the tax. In a highly inflationary environment, this could actually be used to dampen inflation. But in any normally operating economy, the Fed would simply have to fund the deflationary effects of the tax by printing money and buying securities.

Which raises an interesting point: if the Fed will wind up funding the Financial Security fund, why not have the Fed do this directly rather than through monetary policy. The reason, of course, is because taxpayers are on the hook for the Fed's obligations, which means that it would become too obvious that the taxpayers haven't been taken off the hook. Do it in the round-about way and maybe no one will notice.

The "huge vault" is probably unrealistic. What is likely to happen is that the revenue collected will be used to purchase government bonds. The purchase of those bonds will generates general revenue for the federal government. That money will then be spent on the operations of the federal government.

When a financial crisis strikes, the Financial Security Fund will be called upon to stage a rescue. In order to do that, it will have to start redeeming the bonds it purchased or simply hand those bonds over to banks as a form of capital injection. Of course, it will be doing this precisely when the government's other obligations -- unemployment, stimulus spending, etc -- are growing and revenues are declining. This will result in a glut of government bonds entering the market, which will push rates up.

So how does the government avoid a debt crisis? This probably sounds familiar: it has the Fed step into the market to buy up government bonds. In short, the obligations of the fund during a crisis will be borne by the Fed and ultimately by the taxpayer.

There is no way to actually have the US government accumulate a financial security surplus. In one way or another, the surplus results in the purchase of government bonds, the purchase of governmente bonds will generate revenue for the government, and that revenue must be spent.

In the words of humorist P.J. O'Rourke, "Having a government Trust Fund is exactly the same thing as not having a government Trust Fund."